Question: Derive AS and AD curve.

What will happened in AD curve if any expansionary fiscal policy or contractionary monetary policy are being taken? Aggregate Supply: The aggregate supply relation captures the effects of output on the price level. It is derived from equilibrium in the labor market. The wage and price setting relation are as follows:

Combining these two equations by replacing the wage in the second equaiton by its expression from the first gives:

The price level is a function of the expected price level and the unemployment rate. The relation between the unemployment rate, employment, and outuput

Replacing u in the previous equation gives the aggregate supply relation between the price level, the expected price level , and output:

There would be two things: 1. A higher expected price level leads, one for one, to a higher actual price level. 2. An increase in output leads to an increase in the price level. This is the result of four underlying steps: An increase in output leads to an increase in employment. The increase in employment; leads to a decrease in unemployment, therefore a decrease in the unemployment rate. The lower unemployment rate leads to an increase in nominal wages. The increase in nominal wages leads to an increase in costs, which leads firms to increases prices. The AS relation between output and the price level is represented by the AS curve. This AS curve has two characteristics: It is upward sloping.

 It goes through point A, where Y=Yn and P=Pe. That is if output is equal to its natural level Yn, then price level is equal to the expected price level: P=Pe.
Price level, P AS Price level, P AS' AS

Pe' A Pe Pe

A' A

Yn

Output, Y

Yn

Output, Y

This characteristics have, in turn, two implications: When output is above its natural level, the price level is higher than expected; P>P e. and vice versa. An increase in the expected price level shifts the AS curve up and vice versa. Aggregate Demand: The AD relation captures the effect of the price level on output. It is derived from equilibrium in the goods market and financial markets. The two equations that characterizes equilibrium in goods and financial markets are:

Equilibrium in the goods market requires that the supply of goods equal the demand for goods ; this is IS relation. Equilibrium in financial markets requires that the supply of money equal the demand for money; this is the LM relation.

Figure above derives the relation between the price level and output implied by equilibrium in the goods and the financial markets. Figure-(a) draws the IS and LM curves. The IS curve is downward sloping. An increase in the interest rate leads to a decrease in demand and in output. The LM curve is upward sloping; an increase in output increases the demand for money, and the interest rate must increase so as to maintain equality of money demand and the money supply. The initial equilibrium is at point A. Consider an increase in the price level from P to P. Given the stock of nominal money, M, the increase in the price level decreases the real money stock, M/P, and the LM curve shifts up. At a given level of output, the lower real money stock leads to an increase in the interest rate. The equilibrium moves from A to A; the interest rate increases from i to i, and output decreases from Y to Y. The increase in the price level leads to a decrease in output. The implied negative relation between output and the price level is drawn as the downwardsloping curve AD in figure-(b). Points A and A in figure-(b) correspond to points A and A in figure-(a). An increase in the price level from P to P leads to a decrease in output from Y to Y. We shall call this curve the AD curve.

If any expansionary fiscal policy or contractionary monetary policy are taken, impact in AD curve will: Any variable other than the price level that shifts either the IS curve or the LM curve in figure (a) also shifts the AD curve in figure (b). An increase in consumer confidence, which shifts the IS curve to the right and so leads to higher output. At the same price level, output is higher. The AD curve shifts to the right. If there is contractionary open-market operation exists, that will shifts the LM curve up and decreases output. At the same price level, output is lower. The AD curve shifts to the left. We represent the AD relation by

Output is an increasing function of the real money stock, an increasing function of government spending, and a decreasing funciton of taxes.